Concepts in technical analysis Technical Analysis Market Analysis | United States 18 July 2007 A Handbook of the basics Mary Ann Bartels +1 212 449 8038 Technical Research Analyst MLPF&S Market Analysis Technical Handbook [email protected] Fred Meissner, Jr. CMT +1 212 449 2603 Technical Research Analyst We cover the basics of Trend, Momentum and other MLPF&S technical indicators and methods [email protected] Table of Contents Introduction 3 Trends 5 Price Momentum Indicators 14 Reversals 17 The Importance of Volume 24 Support and Resistance 28 Market Breadth 31 Market Sentiment 39 The Fibonacci Concept 43 Putting It Together 49 Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 53. 10633344 Concepts in technical analysis 18 July 2007 Contents Introduction 3 Trends 5 Price Momentum Indicators 14 Reversals 17 The Importance of Volume 24 Support and Resistance 28 Market Breadth 31 Market Sentiment 39 The Fibonacci Concept 43 Putting It Together 49 2 Concepts in technical analysis 18 July 2007 Introduction Price action of stocks, or financial markets in general, is a reflection of human nature. Price trends seem to be determined by investors’ decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. Technical analysis attempts to measure the strength of these trends and to forewarn of potential changes in these trends. Technical analysis focuses on the status and prospects of a company's stock performance. "Technical analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in "the averages" and then deducing from that pictured history the probable future trend". Edwards & Magee Technical Analysis of Stock Trends At any given time, the price of a company's stock is determined by the forces of supply and demand. Supply and demand indications are typically mirrored into transactions data. "The market price reflects not only the differing value opinions of many orthodox security appraisers, but also all the hopes and fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, as well as their needs and the resources – in total, factors which defy analysis and for which no statistics are obtainable, but which are nevertheless all synthesized, weighed and finally expressed into one precise figure at which the buyer and the seller get together and make a deal". Edwards & Magee Technical Analysis of Stock Trends "The art of technical analysis ... is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed". Martin J. Pring Technical Analysis Explained Thus, technical analysis is generally a less time-consuming method of stock selection than is fundamental analysis and is based more on the actual performance of a stock than on its prospects for performance. This benefits investors and/or traders because they can broaden their pool of potential investment vehicles as technical analysis is less time-consuming. They can participate in a trend as it is unfolding because it is more timely. They are more likely to sell a stock that begins to go against them because of less emotional attachment. Technical analysis has undergone a major transformation since its early years. It began when traders noticed recurring price patterns in the securities that they traded and remained the art of visually inspecting price charts for such patterns. Through time, more scientific disciplines contributed to technical analysis. Mathematical expressions were devised to describe momentum, acceleration and changes of trend. Physics weighed in with many of its contributions from mechanics (vector analysis) to electro- 3 Concepts in technical analysis 18 July 2007 magnetism (cycle studies and spectral analysis). Throughout its development, technical analysis has been monitored by statistical concepts that keep tabs on what seems to be working and what doesn’t. In its optimal form, technical analysis truly involves a great deal of scientific concepts and discipline. The indicators that we will bring to your attention have mathematical expressions. They have been back-tested to show statistical validity. Even visual price patterns can be identified by computer algorithms, to a great degree, and tested for their validity. The area of neural network study and the advent of abundant computing power have enabled us recently to test a wide variety of indicators on each individual stock that we wish to follow. We are able to tweak the parameters of these indicators so that they best express the performance of each stock. Indeed, the future of technical analysis seems to be trending toward customizing indicators to best predict individual stock performance. Most traders do not have the software resources or the time to do the extensive optimization that we alluded to in the previous paragraph. So, for practical purposes, we will discuss a few indicators and the parameters that seem to work best across most stocks. In such a context, we need to realize that technical indicators are nothing more than tools, and their reliability varies over time. The more indicators that seem to agree on a certain direction, the more likely that the signal will be valid. The tools that follow should be thought of as inputs that will eventually be used in forming a larger consensus regarding market opinion or specific buy and sell decisions on individual stock issues. These concepts have withstood rigorous testing over many years. There will be times when they will mesh together and work flawlessly. There will also be times when there will be no clear consensus among indicators or they will simply fail. We must stress at the outset that technical analysis is an exercise in probabilities. As such, there will be times when we will have to accept losing trades. But through judicious use of the indicators and some prudent money management, we're very confident that the concepts discussed here will help in your investment decisions. 4 Concepts in technical analysis 18 July 2007 Trends A trend – simply put – is the direction in which the price trend is heading. Typically, there are three choices: Positive or advancing trend. Negative or declining trend. Neutral or sideways trading range. Making an assessment of the prevailing trend is important because most of the money to be made is by positioning your trading with the trend. We want to be buying big in up-trends and selling big in downtrends. In the case of neutral trends, we want to identify the upper and lower limits so that we might buy close to the lows and sell close to the highs. Positive Trend Characterized by higher highs and higher lows In a positive trend each up move extends to new price highs while the sell-offs in between do not decline as far as the price levels seen on previous sell-offs. Drawing a line through the lows yields the positive trend line. Positive trend Source: Merrill Lynch Market Analysis Negative Trend Characterized by lower highs and lower lows In a negative trend each down move extends to new price lows while rallies in between do not advance as far as the price levels seen on previous rallies. Drawing a line through the highs yields the negative trend line. 5 Concepts in technical analysis 18 July 2007 Negative trend Source: Merrill Lynch Market Analysis Neutral Trend Characterized by a sideways trading range In a neutral trend the price pattern typically oscillates between an upper limit and a lower limit. Drawing lines through these upper limits and lower limits identifies the trading range. Neutral trend Source: Merrill Lynch Market Analysis When speaking of trends, it is important to specify the relevant timeframe that you are looking at. It is possible for single chart to show all three trend-types, depending on the time scale on which you focus. The chart below shows why specifying a timeframe in describing a trend is important. This particular chart can show a negative, neutral, or positive trend, depending on the relevant period of time at which one is looking. For example, from December ’98 to December ’99, the stock underwent a long-term downtrend. Between October ’99 and the end of the chart, the price pattern is range-bound, indicating an intermediate-term neutral trend or trading range. Short-term, between January 26, 2000 and the end of the chart, the daily pattern of higher- highs and higher-lows indicates an up trend. 6 Concepts in technical analysis 18 July 2007 SWY chart Source: Merrill Lynch Market Analysis The description of time varies among traders. What an aggressive trader sees as long-term, a more conservative trader might see as short-term. For practical purposes, we will structure our working definitions of time as follows: Short-Term: Typically a few weeks in duration. Intermediate-Term: Typically a few months in duration. Long-Term: Typically a year or more in duration. It has been our experience that most valid interpretations, and the most useful and accurate indicators, are typically geared toward the intermediate-term. Using the intermediate-term timeframe as our focus, we will fudge our time designations when they become somewhat ambiguous. When our expectations fall somewhere between the short- and intermediate-term, we might say shorter-term. When our expectations fall somewhere between the intermediate and long-term, we might say longer-term.